March 28, 2019 - They say, “If you’re a hammer, everything looks like a nail.” And maybe if you are a CLO manager, “every regulation must be about risk retention.” That seems to be the case with respect to the Japan Financial Services Agency’s (“JFSA”) recently published regulatory capital rule (the “Rule”) on securitizations. To be sure, an important part of it touches on risk retention but a deeper dive suggests that the JFSA’s focus extends to the due diligence practices of Japanese banks and the asset quality of the loans in which they are investing through CLOs. Furthermore, the JFSA has structured the Rule in such a way as to give themselves a significant amount of leeway in interpreting and enforcing the Rule. Stated differently, it appears that the uncertainty in the Rule is a feature, not a bug. Let’s take a look.
The Rule has two principal components. First, as a threshold matter, and irrespective of whether a securitization is risk retention compliant, a Japanese investor must hold increased capital against any securitization investment unless it establishes systems to continuously collect comprehensive information on the risk characteristics of the securitization exposure it holds and puts in place controls and procedures necessary to implement the above requirements. This is a continuing obligation for Japanese investors and is a related to, but completely separate from, the second prong of the Rule, which focuses on the quality of the underlying assets. While scant attention has been paid to this first prong, it appears designed to give the JFSA maximum authority to ensure that Japanese investors, especially smaller ones, refrain from investing in securitizations unless they develop the appropriate due diligence and control capabilities.
The second part of the Final Rule requires that Japanese investors hold excess capital against all securitization exposures unless (ii) the “originator” (including a CLO manager) retains at least 5% of the fair value of the securitization, or (ii) “it is determined, on the basis of the originator’s involvement in the original assets, the nature of the original assets or any other relevant circumstances that the original assets were not inappropriately formed.”
As previously explained, JFSA’s comments and FAQs make clear what should not be part of that assessment but the factors they do identify are quite vague. This vagueness supports the view that the JFSA wants discretion in enforcing the Rule.
But doesn’t risk retention cure all? On its face, the Rule does appear to hand Japanese investors a free pass so long as managers retain risk, irrespective of the quality of the underlying loans. Perhaps that is so, but one must not lose sight of the first prong that requires banks to demonstrate they are collecting information on the risk characteristics of securitizations. Risk retention is not a free pass.
So, is this as bad as it sounds? Probably not. All current indications are that Japanese investors are still open for CLO business, albeit with an enhanced level of due diligence, suggesting that the JFSA is on board with that. The message instead is that the JFSA’s Rule is dynamic, they will be keeping a close eye on the US loan market, and they have built into the Rule the tools they need if they believe the need arises.